Absolute rules

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Chastened by the experience of a three-year bear market in equities, European pension funds are moving from away from traditional benchmarks and relative returns toward ‘liability-driven’ strategies and absolute returns. Certainly this is the picture that alternative asset managers, and some traditional asset managers, are painting. Mark Rosenberg, head of SSARIS, the joint venture fund of funds operated by State Street Global Advisors and the Dutch pension fund ABP, said recently that a “paradigm shift” has occurred among investors that would transform absolute returns into a major asset class. And he predicted that absolute return strategies would be a component of most pension portfolios by the end of the decade. With some justification. In the bull market of the 1990s, even a fund that under-performed its benchmark made money for pension funds, since the entire market was rising. In today’s conditions, pension fund managers are unlikely to tolerate a fund that outperforms its benchmark but still loses money. There have already been signs of impatience. Last year the Swedish Foundation for Strategic Research took part of its Swedish equities portfolio away from mainstream managers SEB and Nordea and handed it to two more adventurous competitors, Carlson Investment Management and Catella Capital. Björn Brandt, the foundation’s director of administrator, explained: “They have a style which fits the foundation’s philosophy, which is more to have an absolute return, and to be less inclined to follow an index.” Although it is possible to have ‘long-only’ absolute return strategies, pursuing an absolute return strategy requires exposure to alternative investments, principally private equity and hedge funds. Private equity typically accounts for only a fraction of European pension funds’ portfolios, albeit a significant fraction in the case of Dutch pension giants ABP and PGGM, where they represent 2.5% and 7% of assets respectively. However, the Sixth AP Fund, one of the ‘buffer funds’ for Sweden’s PPM pension system, is one fund which plans to be wholly invested in private equity. It has committed its entire assets of Skr11.6bn (e1.3bn) to investment in private equity funds or companies owned directly by the fund. This has entailed a switch this year from a relative return strategy to an absolute return strategy. AP6’s former return target was for the average return over five years to exceed the return of the SIX index. The new target means that AP6 must generate an average annual return above an absolute return target in a rolling five-year perspective. There is no single target to achieve. The absolute return target will reflect the return each type of asset is expected to provide and will therefore vary depending on the risk level of the asset. There are some doubts whether private equity should be included in an pension fund’s absolute returns strategy. Jean-Pierre Steiner, director corporate pension and risks services at the €4bn Nestlé pension fund in Switzerland, says: “Most people classify private equity as an alternative investments, as we do. But it’s certainly not an absolute return strategy, especially the venture capital part of it.” Steiner suggests that the performance of private equity in the past two years has been roughly similar to that of quoted equity. Hedge funds, however, do offer positive returns, he says. Nestlé is a leading indirect investor in hedge funds as part of its absolute returns strategy (see box). Many of its funds are selected and managed by Unigestion, which specialises in managing money for a group of Swiss pension funds and has been putting its own money into hedge funds since 1986. Patrick Fenal, chief executive of Unigestion, says that other pension funds now want to follow Nestlé’s lead. “Pension funds are starting to look at these defensive absolute return strategies. They are asking themselves why they only have only 1% in an asset class that has performed so well, and they are ready to put pressure on their boards to increase the percentage invested in hedge funds. “ However, he warns that timing may be a problem. “Funds are buying into this asset class at probably the worst moment, at least if they are expecting performance like in the past. If they expect 11% return they may have a surprise. In Switzerland and Europe they can expect 6–8%, which is still good compared with fixed income.”

Fenal also warns that funds that enter the market too rapidly face a steep learning curve. “In 1996 the hedge fund market didn’t look so great and Nestlé were taking almost a contrarian approach. They took their time and they learnt as they went. Today, everyone wants to increase their hedge fund investment quite rapidly.” Another problem that new entrants to the fund of funds markets face is that the best funds are now closed. “There is a huge question mark here because you have to go with new managers, which won’t be the same perhaps in terms of risk control,” he says. Pension funds have other options in their absolute return strategies besides indirect investment in private equity and hedge funds. One that is attracting interest is the use of market-neutral strategies. Here again, the Nestlé pension fund has taken the lead. Earlier this year it set up an operation to pursue a sub-strategy of delivering an absolute return whichever direction the market moves Steiner explains how this works: “We use paired trades or more exotic strategies, even commodities or currencies – we don’t really mind. What we are trying to do is put in an asymmetric strategy in which we are willing to give up some of the upside to reduce the downside significantly. “We still need to make some bets direction-wise, not only on equities but on other types of underlyings, either through options or a combination of several positions. The aim is to achieve a really asymmetric profile.” The task has been handed to the managers who run the portfolio of traditional assets. Steiner says that this could improve the skills of his portfolio managers all round: “There is an educational side to this, encouraging portfolio managers to think in different terms to a benchmark. I suspect that being forced to think in absolute terms will also help improve their skills in the traditional benchmark-related portfolio management.” UK pension funds are also looking at market-neutral strategies – in particular the use of structured instruments – to achieve absolute returns. One technique is alpha transport – moving alpha (a manager’s outperformance of the market) to a target benchmark using a swap contract or a combination of futures and swaps. This allows a pension fund manager to obtain the absolute returns of a hedge fund manager without the volatility of the hedge fund market, says John McLaughlin, executive director Schroders in the UK. “Pension fund managers don’t want the volatility of the underlying hedge fund market, which could be plus or minus 15% but they do want the alpha – that is, the manager’s outperformance of the underlying market – which could be 3% or 4%.” McLaughlin says that alpha transport enables pension funds to hedge their exposure to funds of hedge funds by swapping a fund of hedge funds benchmark for another less volatile or more appropriate one; for example, long-dated government bonds. “Funds of hedge funds will typically choose three-month Libor as a benchmark. That’s not very attractive to pension funds with long term investment objectives So what we are doing for UK pension funds is moving them into something that is closer their benchmark which is long-term growth. We are removing the alpha from the performance of the underlying hedge fund market and putting it into a gilts benchmark.”

The growing interest of European pension funds in absolute returns has, in some cases, been prompted by the development of new pension vehicles. Michael Freisberg, managing partner of Towers Perrin in Frankfurt points out that the introduction of the new Pensionsfond vehicle in Germany as part of the Riester reforms has encouraged some companies to look to alternatives to provide the necessary guarantees to their pension promise. “There are some promises that implicitly guarantee a certain interest and companies are looking to cover discounted interest with an alternative investment. They are now looking increasingly for more unconventional investments as a counterpart to a pure equity portfolio.” However, Freisberg says the exposure to alternatives is likely to be cautious. “German institutional investors as far as pension fund money is concerned are still a little bit conservative, although we can observe a very small move in the market towards alternatives. So at present the conservative approach is going forward combined with alternative investments, but in a very small way. They are doing it step by step to see how it works.” This testing of the water is probably typical of the approach of European pension funds in their moves away from benchmarks towards absolute return strategies. Pension funds that have been scalded by the collapse in equity returns are unwilling to repeat the experience with another asset class.